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Tag Archives: Vanguard

In a recent article on MarketWatch, Chris Martenson asserts that the Fed’s low interest rate policy and quantitative easing in recent years is deliberately stealing from savers. This article has elicited a big response, with almost 800 comments and almost 2000 likes on Facebook. The key point of the article is that the Fed’s policy of holding down interest rates to stimulate the economy has reduced the income provided by Treasury bonds, savings accounts, and certificates of deposit (CDs) to extremely low levels. In this way, the Fed’s policy can certainly be viewed as harmful to people trying to live on the income from bonds and other very low risk investments. This Fed-bashing rhetoric is far from the whole story, though.

The total impact of very low interest rates on savers and conservative investors is somewhat more complex than the MarketWatch piece suggests. Subdued inflation in recent years, one of the reasons that the Fed cites for keeping interest rates low, also means savers are seeing lower rates of price increase in the goods and services they buy. With very low current inflation, you simply don’t need as much yield as when inflation is higher. It would be wonderful for conservative investors to have low inflation and high yields from risk-free accounts, but that situation is effectively impossible for extended periods of time. All in all, low inflation is typically a good thing for people living in a fixed income.

Another effect of continued low interest rates is that bond investors have fared very well. The trailing 15-year annualized return of the Vanguard Intermediate bond Index (VBMFX) is 5.4%, as compared to 4.5% for the Vanguard S&P 500 Index (VFINX). Falling rates over this period have driven bond prices upwards, which has greatly benefitted investors holding bonds over this period.

One interesting related charge leveled by the MarketWatch piece (and also in a recent New York Times article) is that the Fed policy has exacerbated income inequality and that the wealthy are benefitting from low rates while less-wealthy retirees living on fixed incomes are being hurt. Low interest rates have helped the stock market to deliver high returns in recent years and it is wealthier people who benefit most from market gains. In addition, wealthier people are more likely to be able to qualify to refinance their mortgages to take advantage of low rates. The implication here is that less wealthy people cannot afford to take advantage of the benefits of low rates and that these people, implicitly, are probably holding assets in low-yield risk-free assets such as savings accounts or CDs. This is, however, somewhat misleading. Poorer retired households receive a disproportionate share of their income from Social Security, which provides constant inflation-adjusted income.

While investors in Treasury bonds, savings accounts, and CDs are seeking riskless return, money held in these assets does not help to drive economic growth, and this is precisely why the Fed policy is to make productive assets (in the form of investments in corporate bonds and equity) more attractive than savings accounts and certificates of deposit. So, the Fed is attempting to drive money into productive investments in economic growth that will create jobs and should, ultimately, benefit the economy as a whole. One must remember that the Fed has no mandate to provide investors with a risk-free after-inflation return.

It is certainly understandable that people trying to maintain bond ladders that produce their retirement income are frustrated and concerned by continued low interest rates and the subsequent low yields available from bonds. Given that inflation is also very low, however, low bond yields are partly offset by more stable prices for goods and services. It is true that the Fed’s policies are intended to get people to do something productive with their wealth like investing in stocks, bonds, or other opportunities. It is also the case that older and more conservative investors world prefer to reap reasonable income from essentially risk-free investments. Substantial yield with low risk is something of a pipe dream, though. Investors are always trying to determine whether the yield provided by income-generating assets is worth the risk. We may look back and conclude that the Fed’s economic stimulus was too expensive, ineffective, or both, but this will only be clear far down the road.

There have been a number of surprises for investors in 2014. Bonds have markedly out-performed stocks for the year-to-date. The S&P500 is up 2.4% since the start of 2014, as compared to the Barclays Aggregate Bond Index, which is up by 3.5%. Even more striking, the iShares 20+ Year Treasury Bond ETF (TLT) is up by 12.5% YTD and the Vanguard Long-Term Bond fund (VBLTX) is up by 11.4% YTD. Interestingly, REITs have been also experienced a substantial run-up in 2014 so far. The Vanguard REIT Index fund (VGSIX) is up 16.1% YTD and the iShares U.S. Real Estate ETF (IYR) is up by 14.4% YTD.

To understand the rally in REITs, it is useful to start with an overview of this asset class. REITs are neither stock (equity) nor bond (fixed income). A REIT uses investor money, combined with borrowed money, to acquire real estate. The properties that they acquire can be office buildings (BXP, SLG), apartment buildings (EQR, UDR), healthcare facilities (HCP, HCN), or even digital data centers (DLR). The returns vary between the specific types of property owned. REITs make money from renting their facilities out. Please note that I am discussing only equity REITs (those which own property). There is a secondary form of REITs that buy baskets of mortgages. These are called mortgage REITS (mREITs).

REITs are classified as ‘pass-through’ or ‘flow-through’ entities and pass at least 90% of their taxable income to their shareholders each year. For this reason, REITs are often favored by income-oriented investors.

REITs have their own unique measures of value and drivers of performance. Rather than price-to-earnings ratio, a measure of the valuation of stocks, the preferred measure of valuation for REITs is price-to-funds from operations (FFO). A notable feature of REITs is their exposure to interest rates. In general, stocks go up when interest rates rise, while bonds fall. When interest rates decline, the reverse tend to be true: stocks decline and bonds rise in value. REITs tend to have a fairly neutral response to changes in interest rates, although this varies. To the extent to which REITs need to borrow in the future due to rolling credit or new financing, their costs rise when interest rates rise. REITs often also have the ability to raise rents, however, so that their revenue can also rise when the costs of residential or commercial real estate rise with inflation. In addition, because REITs own a physical asset (property), the value of the assets owned by the REIT tend to go up with inflation.

An examination of the performance statistics of REIT funds illustrates their properties quite clearly.

REIT funds vs. major asset classes (10 years through April 2014)—Source: Author’s calculations

The returns above are the arithmetic average of returns over the past ten years, including reinvested dividends. Beta measures the degree to which an asset tends to amplify or mute swings in the S&P500. The betas for VGSIX and IYR show that these funds tend to rise 1.3% for every 1% rise in the S&P500 (and vice versa). These broad REIT funds tend to do well in rising stock markets and will also tend to perform worse than the S&P500 when the market crashes. The S&P500 fell 36.8% in 2008, for example, and IYR fell 39.9%, for example. The high beta is only one factor that determines the returns from these REIT index funds, however. Despite a massive decline in real estate in 2008, the average annual return for these two REIT funds has been very high over the past ten years. The volatility levels exhibited by these REIT funds is, however, very close to that of emerging market stocks, as shown above.

The best way to understand the unique features of REITs is to look at the correlations in the returns between asset classes, bond yields, and the returns from a traditional 60/40 portfolio (60% stocks, 40% bonds).

Correlations between monthly returns over the past ten years (through April 2014) for major asset classes, 10-year Treasury bond yield, and the returns from a 60/40 portfolio—Source: Author’s calculations

Equity indexes tend to have positive correlations to Treasury bond yields (because yield goes up when bond prices go down, and vice versa). This effect is evident in the table above. S&P500 stocks (represented by SPY) have a +30% correlation to the 10-year Treasury yield. The same relationships hold for the other major equity classes in the table above (EFA, EEM, QQQ, and IWM), with correlations to the 10-year Treasury yield ranging from 20% (EFA) to 36% (IWM). In 2013, Treasury bond yields rose and stock indexes gained substantially. By contrast, the returns of bond funds (AGG, TLT) are negatively correlated to the 10-year Treasury bond yield. The returns from these funds tend to be positive when Treasury yields are falling and vice versa.

Treasury bond yields follow interest rates and inflation. When rates or inflation rise, bond yields rise because investors sell Treasury bonds to avoid getting caught with relatively low-yield bonds in a higher rate environment. The selling continues until the yield on the bonds is in line with new rates. This is why returns on the two bond funds are so negative correlated to Treasury yield. When yields go up, bond prices fall and vice versa.

VGSIX and IYR have 6% and 7% correlations to the 10-year Treasury yield—which means that these REIT funds are not highly sensitive to movements in bond yields. While investors were betting on rising yield in 2013, opinion seems to have shifted in 2014. If you are looking for asset classes that don’t require a bet on whether interest rates will go up or down, REITs look pretty attractive.

The correlations between the returns from each asset class and the returns from a 60% stock / 40% bond portfolio show the degree to which adding these asset classes to a simple stock-bond mix is likely to provide diversification benefits. The higher the correlation, the less diversification benefit you can expect. The key idea in diversifying a portfolio is to combine assets with low correlations so that when one is losing money, others are likely to be doing something different (hopefully rising in value). As compared to the major equity asset classes, the REIT funds have a lower correlation to the 60/40 portfolio. This, in turn, suggests that REITs can provide more diversification benefit than equities to a portfolio that currently holds stocks and bonds.

In summary, the basic narrative to explain the rally in REITs goes something like this. REITs provide substantial income compared to bonds and equities, as well as being essentially interest rate neutral. While REITs are a volatile asset class, the relatively low correlation between REITs and equities provides diversification benefit to a portfolio of domestic stocks and bonds, as well as providing some modest protection from rising interest rates. REITs appear have come back into favor after being sold off during and after the so-called taper tantrum of 2013, with yield-hungry investors leading the charge. In a slow-growth environment, with the Fed indicating that they foresee an extended period of low rates, REITs look quite attractive. The caveat to the positive view on maintaining an allocation in REITs is that there are substantial differences between the yield, risk, and interest rate exposure and that REITs have historically been a volatile asset class. Unless you firmly believe that you can outsmart the broader market, REITs should be thought of as a long-term income producer and diversifier. For those investors who have maintained a strategic allocation to REITs, the gains in 2014 YTD have helped to bolster portfolio returns as equities have provided very little to investors beyond their dividends. The downside to this positive narrative, however, is that increased prices for REITs translate to lower yields for today’s buyers.

Vanguard has just reduced the expense ratios of 24 of its ETFs. The reductions are fairly substantial. What I noticed, in particular, is that the reductions include sector-specific ETFs.

The Vanguard Energy ETF (VDE), the Vanguard Information Technology ETF (VGT), the Vanguard Telecom ETF (VOX), and the Vanguard Utility ETF (VPU) each now have 0.14% expense ratios vs. 0.19% previously. While the expense ratios of these funds were already low, the new expenses are 26% lower than before. Continue reading →

The New York Times had a piece this weekend that proposes a simple portfolio solution for worried investors.

Are you ready for this?

The portfolio is a 50% allocation to stocks and 50% to bonds. The conclusion that the 50/50 portfolio makes sense is based on a study by Vanguard published in October 2011 that finds that this allocation seems to generate consistent returns, regardless of whether the economy is in recession or expansion. The study is based on portfolio performance from 1926 through June 2009.

The 50/50 portfolio generated an average annual return of 7.75% per year during recessions and 9.9% per year during expansions. Continue reading →

Have retirement accounts balances rebounded from the financial crisis?

Reports from both Vanguard and Fidelity put the average balance for U.S. 401(k) plans at a record $75,000 (as of March 31, 2011). The first report, released from Fidelity in May, showed that the average 401(k) balance rose to $74,900—up 12% over the last year. This marked an all-time high since Fidelity began tracking account balances back in 1998. Fidelity is the largest single administrator of 401(k) plans, with 11 million accounts, so these numbers are of considerable interest to me.

Vanguard also announced that the average balance of its 401(k) accounts rose to about $75,000 in its annual How America Saves 2011 report.

At first glance, the numbers are compelling and encouraging. Both Vanguard and Fidelity report the largest increase in contributions since both firms started tracking this data (in 1999 and in 1998, respectively). However we need to take a closer look to see Continue reading →

The Employee Benefit Research Institute (EBRI) does an annual study called the Retirement Confidence Survey (RCS). The RCS typically shows that Americans are not saving enough for retirement and that many people simply have no idea how much they need to save. The 2011 study is no exception. Among other things, the RCS asks participants how they are estimating how much they need to save and where their current estimates fall.

The 2011 survey finds:

Only 42% of workers have even tried to calculate how much they need to accumulate in order to retire

31% of workers think that they can retire with total savings of $250,000 or less

19% of workers think that they can retire with total savings of $250,000 to $500,000

These numbers are pretty close to the RCS findings in the past, and the longer these numbers hold, the more it is clear that the self-directed retirement planning process is not succeeding. Continue reading →

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